Refinance and Other Options When Your Home Is Underwater

August 16, 2010, Revised September 5, 2010, May 28, 2012

"My home is underwater, worth about 216K as against a loan balance of 240K. I can refinance the loan under the HARP program, reducing the rate from 5.75% to 5%, at a cost of $3400. Should I refinance? Or just try to sell the home and bite the bullet?”

The first step should be to clarify your options, which are more numerous than you indicate. There are at least two legitimate ways to give up the house, and if you stay put there are two ways to refinance.

Option 1 is to sell the house and pay the lender the difference between sale proceeds and loan balance. The advantage is that you are out clean, with no black mark on your credit record and no lingering debt. The disadvantage is that it will cost you $30,000-$40,000 for which you will receive nothing but a thank-you – and probably not even that.

Option 2 is to negotiate a short sale with the mortgage lender where the lender accepts the sale proceeds and removes the mortgage lien. The advantage over option 1 is that no cash outlay is required. The disadvantage is that the short-sale drops your credit score. In addition, the lender may retain an unsecured claim against you for the amount of the balance not repaid with the sale proceeds. They don’t always do that, but increasingly this has become the practice.

Option 3 is to accept an offer to refinance from your current lender, who is the only lender who will deal with you because of the negative equity. Using my refinance calculator 3a, it will take about 3 years for the rate reduction from 5.75% to 5% to cover the refinance costs of $3400. This option also doesn’t require any out-of-pocket expense, since you can finance the cost. However, unlike options 1 and 2 you retain the negative equity. If you decide to sell within the next few years, the refinance costs will exceed the benefits of the rate reduction, and you will still have the negative equity to pay off.

Option 4 is to do a cash-in refinance to reduce your balance to 80% of current value. It is plausible that if you do this, the refinance rate will drop from 5% to 4.5%. Assuming a $216,000 value, you would have to pay down the balance by $67,200 and cover the $3400 in closing costs, for a total required investment of $70,600. If you have that kind of money, it is a great investment, since it carries no risk and will earn 6.23% over 2 years, 7.74% over 5 years, and 8.30% over 10 years. I calculated these on the new cash-in refinance calculator 3f I developed with Chuck Freedenberg.

I am not going to discuss the “walk away” option where you shrug off your contractual obligation and allow the lender to foreclose. I don’t recommend this option.

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